Unlike Gold - Stimulus Is Effective Only Under Certain Circumstances

This essay is based on the Premium
Update posted on November 19th, 2010

A recently published
paper that studied the stimulus efforts in 44 countries showed some interesting
findings. Ethan Ilzetzki of the London School of Economics and Enrique G.
Mendoza and Carlos A. Vegh of the University of Maryland argued in their
National Bureau of Economic Research paper that fiscal stimulus can be quite
effective in low-debt countries with fixed exchange rates and closed economies.

But stimulus measures are generally not as effective in countries like the
U.S. with high debt and floating exchange rates. The authors of the paper pointed
to a series of specific circumstances that throw a wrench into the effectiveness
of increasing public spending: How much of the stimulus money ends up flowing
abroad? How do investors respond to fear of future interest rate increases?

New York Times columnist David Brooks mentioned the study and wrote in a column this
week:

When you look around the world at the countries that have come through
the recession best, it's not the countries with the brilliant and aggressive
stimulus models. It's the ones like Germany that had the best economic fundamentals
beforehand.

It all makes one doubt the wizardry of the economic surgeons and appreciate
the old wisdom of common sense: simple regulations, low debt, high savings,
hard work, few distortions. You don't have to be a genius to come up with
an economic policy like that.

Our take is that the Fed knows that the stimulus is going to work as advertised,
but they decided to go with it anyway, simply because they are desperate.

Speaking of geniuses and economic surgeons, in an unusual move, top Fed officials
came out this week to defend their recent move to inject $600 billion more
into a sluggish economy. The Federal
Reserve has come under attack both at home and abroad with a torrent of
criticism from foreign leaders, Congressional officials, economists and Alan
Greenspan, the former Fed chairman.

Perhaps what unsettled the Fed officials most was an opinion piece by Greenspan
in The Financial Times last Thursday. Greenspan said the United States was "pursuing
a policy of currency weakening" and increasing the risks of trade protectionism.

Another barrage of criticism came in the form of an
open letter this week to Ben Bernanke, in which a group of conservative
economists, writers and investors urged that the Fed's action "be reconsidered
and discontinued," arguing that the bond purchases "risk currency debasement
and inflation." The group included Michael J. Boskin, a former chairman of
the White House Council of Economic Advisers; the historian Niall
Ferguson; and the economist John B. Taylor, one of Bernanke's most prominent
critics.

In a rare on-the-record interview, William C. Dudley, president of the Federal
Reserve Bank of New York said that the Fed's move was not intended to affect
the value of the dollar, but rather to encourage a quicker, stronger recovery.
He said:

We have no goal in terms of pushing the dollar up or down. Our goal is
to ease financial conditions and to stimulate a stronger economic expansion
and more rapid employment growth.

Dudley rejected the idea that the Fed might be setting the stage for uncontrollable
inflation in the future. Dudley cautioned that: One shouldn't view this
instrument (quantitative easing) as a panacea or a magic wand that's going
to make the economy recover rapidly. It's going to be a long and bumpy road
to a strong and vigorous expansion, but this will be helpful rather than hurtful.

In the very long-term chart this week, we see that gold has not moved above
the upper border of the very long-term trading channel. As we have stated in previous
essays, this is an important resistance level. It was likely that some
consolidation will be seen in the near-term so this should not be of any great
concern as it is quite a natural phenomenon.

The important point is that our next target level, after moving above the
trading channel will be close to $1,600. This target has been arrived at by
utilizing two technical tools. One is the upper border of the accelerated trading
channel and the second is extrapolation made my applying the 1.618 Phi (φ)
number. Both tools indicate a likely move to the $1,600 level perhaps in the
first quarter of 2011.

Our second gold chart this week looks at gold vs. corporate bonds. Clear trends
have been seen in the past and for this reason we are including this chart
as yet another perspective in analyzing gold's current trends. Previous consolidation
periods and breakouts have been followed by strong rallies with very sharp
increases seen after the breakout occurs. This chart clearly allows you to
separate the consolidation phase from the big rallies. Additionally, once the
breakout is seen, the rally takes gold quickly higher. It seems that this may
indeed be happening now.

As we have previously stated, if this index level holds above 5.0, a major
rally is quite likely. What we have seen in recent days is, even with slight
corrections and taking intra-day highs into account, this level has indeed
held. The small consolidation seen immediately after a breakout is quite normal,
and should not be viewed as bearish.

These are not the only bullish long-term charts that we have prepared for
you this week. Let's take a look at the XAU Index below.

This week's XAU Gold/Silver Index chart reveals that index levels have moved
above previous highs and the breakout is presently being tested. Although not
yet validated, this is a significant development, as the index values are here
for couple of days. Therefore the situation appears to be bullish. It seems
unlikely that this trend will reverse.

Looking back to 2005, a very similar trend can be seen. At that time (in the
final months of 2005), the index moved to the level of the previous highs,
declined and then moved up significantly. It seems quite possible that today's
trend will follow this very pattern. We will continue to monitor this situation
closely and utilize our Market Alert capabilities when warranted.

The HUI Index serves as a proxy for gold stocks, and on the above chart we
have confirmation of points made earlier in this essay. The rally here is significant
and the breakout is being verified. Two important resistance lines are being
tested as support. So far the first support line was not decisively broken.
We've seen intra-day moves below it, but finally the HUI index levels are now
above it. This is a bullish indication for mining stocks going forward.

Summing up, the long-term situation appears very bullish for gold,
silver, and mining stocks. Both, gold and mining stocks appear to be gathering
strength for the next big run up. Consequently, the long-term capital should
be already invested in the precious metals market.

Thank you for reading. Have a happy Thanksgiving holiday weekend and a profitable
week!

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Przemyslaw Radomski, CFA (PR) is a precious metals investor and analyst who
takes advantage of the emotionality on the markets, and invites you to do
the same.

His company, Sunshine Profits, publishes analytical software that anyone can
use in order to get an accurate and unbiased view on the current situation.

Recognizing that predicting market behavior with 100% accuracy is a problem
that may never be solved, PR has changed the world of trading and investing
by enabling individuals to get easy access to the level of analysis that
was once available only to institutions.

High quality and profitability of analytical tools available at www.SunshineProfits.com are
results of time, thorough research and testing on PR's own capital.

PR believes that the greatest potential is currently in the precious metals
sector. For that reason it is his main point of interest to help you make
the most of that potential.

As a CFA charterholder, Przemyslaw Radomski shares the highest standards for
professional excellence and ethics for the ultimate benefit of society.

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